Schemes that reward whistleblowers who provide evidence of corporate fraud have been effective in the US, but have generally been resisted in Europe. This column argues that a policy that trades off rewards to those who blow the whistle against punishment for fabricating evidence would increase both detection of, and punishment for, fraud. This will only be effective, however, if whistleblowers are protected from retaliation and the policy also invests in making court findings more accurate.

Corporate fraud is endemic. Dyck et al. (2013) estimated that between 1996 and 2004, about 15% of large publicly traded US corporations engaged in fraud. These crimes have an expected cost of $380 billion. Following corporate scandals at Enron, Parmalat, Worldcom, Siemens, Madoff, Volkswagen, and the Libor and Forex manipulation schemes, some European governments are debating whether to follow the US and introduce financial rewards for whistleblowers who report corporate crime to the authorities.

Corporate whistleblowers are usually employees. They often report the problem externally only after they report it internally and are ignored, sanctioned or harassed by their superiors. After blowing the whistle they are often subjected to unverifiable internal retaliation. Realising this, in recent years the US authorities have increased the use of financial rewards for whistleblowers, similar to the rewards that have been used since the US civil war for rooting out fraud in federal contracts (Nyrerod and Spagnolo 2017).

Discovering crimes by eliciting existing information from witnesses or accomplices may be more efficient than finding new information through an investigation. If it is difficult to protect whistleblowers from retaliation, and if retaliation against whistleblowers is difficult for a court to ascertain, financial rewards for whistleblowers can be seen as compensation. In addition, if they are large enough, rewards provide strong incentives to report corporate infringement.

European authorities are still wary of the explicit, structured financial incentives for whistleblowers that are increasingly popular with US enforcement agencies. This is partly because they fear large incentives lead to unintended harmful consequences when management is poor or there is a lack of administrative capacity, and also because historically this type of incentive was used by authoritarian regimes against internal opponents. For these reasons, US enforcement practices may not be viable in Europe.

The origin of the animosity to rewards for whistleblowers from corporate lawyers and some of the regulatory authorities in Europe, however, is less clear. For example, in 2014 the two main UK financial market watchdogs – the Prudential Regulation Authority of the Bank of England and the Financial Conduct Authority – wrote a joint response to a request for opinion from the Parliamentary Committee on Banking Standards. "There is as yet no empirical evidence of incentives leading to an increase in the number or quality of disclosures received by the regulators," it said.

This is incorrect. Dyck et al. (2010) showed empirically that whistleblower rewards under the False Claim Act in the US were highly effective in encouraging employees to blow the whistle. Engstrom (2012, 2013, 2014) offered additional empirical evidence of positive effects of this whistleblower reward system. Baloria et al. (2015) showed that opposition to whistleblower rewards came mostly from companies with poor corporate governance.

More recently, Wilde (2017) provided evidence that whistleblowing deters financial misreporting and tax aggressiveness. Call et al. (2017) found that, when whistleblowers provide evidence in financial misrepresentation enforcement actions, proceedings begin sooner, there are higher monetary sanctions for the guilty firm, there is a higher likelihood that criminal sanctions are imposed, and when executives are convicted they spend more time in jail.

Opponents nevertheless claim that these schemes induce reports based on false or fabricated information. Evidence from the US, however, suggests that this has not been a major problem. US agencies argue that, when appropriately designed and managed, they both increase crime detection rates and largely pay for their administration costs (Nyrerod and Spagnolo 2017).

A model of whistleblower incentives

In recent work, we develop a model of the interaction between rewards for whistleblowers, sanctions for fraudulently reporting false or fabricated information, judicial errors, and standards of proof in two types of court case (one based on a whistleblower’s allegations, and the following one, typically neglected, for defamation or perjury against a whistleblower who loses the first case) (Buccirossi et al. 2017).

The policy debate typically neglects to consider that schemes can be designed in many ways, and that every legal system already has tools in place that are specifically designed to prevent fraudulent claims based on false information, such as defamation and perjury laws. Therefore the risk of an increase in false or fabricated claims can be reduced by strengthening these tools, rather than by giving up on the potential of whistleblower rewards.

The risk that high-powered incentives lead to many fabricated accusations can be controlled directly through severe sanctions against defamation, perjury and information fabrication. It could also be controlled by the adoption of a stricter standard of proof for information provided by witnesses who stand to gain from a conviction. This may reduce the incentive to forge information linked to rewards, but at the cost of a lower conviction rate. Alternatively, the risk of fabrication could also be reduced by lowering or capping rewards for whistleblowers. But all these strategies have costs, because they would mean weaker enforcement, and so reduce the deterrent effect on corporate fraud.

Therefore, the optimal policy will likely involve a mix of strategies. Variation in the efficiency and precision of legal systems also means that different policies may be optimal in different institutional environments.

We discover that to design an effective reward programme, in which whistleblowers do not deliberately present false claims but do file reports when a firm misbehaves, it is crucial to find an optimal balance between the reward offered to successful whistleblowers and the sanctions against those convicted for knowingly reporting false information. Given other parameters, a balanced ratio between these two parameters leads to an optimal programme, suggesting that severe sanctions against whistleblowers convicted for forging information are necessary to compensate for large rewards, and vice versa.

Because retaliation from employers is possible, and not all forms of retaliation can be observed by a court, we show that there is a minimum size of reward, below which whistleblowing will not take place at all, that is independent of the ratio of sanctions and rewards. If the risk is high that a firm will retaliate, and the weaker the whistleblower protection, any reward must also substantially exceed the sanction imposed on a mendacious whistleblower.

An overly strict standard of proof, with very few false positives and therefore many false negatives, induces whistleblowers to never report and the firm to always commit wrongdoing. Similarly, when the standard of proof is too low, the many false positives induce whistleblowers to always blow the whistle, whether or not the firm is guilty. The standard of proof must therefore be chosen with due care to avoid turning these schemes into failures.

We find that when the top management is involved in the wrongdoing, internal whistleblower channels can be easily misused to undermine external whistleblower channels. They allow management to bribe the employee that reports internally, so that the information does not reach law enforcement agencies. As a consequence, the programmes should not require the whistleblower to first report internally.

Improving the accuracy of courts reduces both types of error, and is the only policy with unambiguously positive effects. This policy is costly, but a well-functioning whistleblower reward scheme may reduce detection and prosecution costs and at the same time increase recoveries, thereby compensating for the costs of increased accuracy.

Whistleblower schemes are useful instruments

From a short-run perspective, therefore, our results imply that whistleblowing reward schemes are useful instruments that can be effectively designed and administered – and should therefore be welcome if there is interest and political will to fight corporate misbehaviour, provided the court system is sufficiently precise. Our results also imply that, in environments with weak institutions, where court precision and administrative capabilities are low, these tools are likely not to perform as one would hope. In this case, they should be avoided.